AN INTRODUCTION TO INVESTING IN STOCKS
If you are reading this , chances are you know investing in stocks can be a great way to grow your savings. Although a lot of new investors may know that investing in stocks, Exchange Traded Funds (ETFs) and Mutual Funds can grow your net worth, they may not know the difference between these investing vehicles and how to use them in building a portfolio.
The purpose of this post is to provide an overview of what stocks are and what investing in stocks over the long-haul might look like based on what has been achieved historically. As we have entered the first global bear market in over ten years, we will also review some common investment jargon, and what it all means for your future portfolio.
What are Stocks?
First and foremost, what are stocks? Stocks, also known as shares or equity, are a type of security that signifies proportionate ownership in an issuing corporation, which entitles the stockholder to that proportion of the corporation's assets and earnings.
In short, a stock represents a share of equity ownership of the company that issued the stock. So investing in stocks is essentially taking an ownership stake in a company with the expectation that the company will be worth more in the future than it is now.
What is the Stock Market?
Second, what exactly is the stock market? Simply put the stock market refers to the collection of markets and exchanges that facilitate the regular activities of buying, selling, and issuance of shares of publicly held companies.
Investors and traders are constantly trading shares as they shift their attention to companies that will grow and be worth the most down the road. The stock market facilitates trading of these shares.
Why do Companies Issue Stocks?
So now that we know what stocks are and what the stock market’s role is in trading, let’s look at why companies issue stocks in the first place. The main reason is public share issuance allows a company to raise capital from public investors.
The transition from a private to a public company can be an important time for private investors to realize gains. When a company goes public, the new shares are typically issued at a premium price to the private shares that were issued to early investors of the company.
Although companies can raise money privately from venture capitalists and private equity funds, this tends to become increasingly difficult as the company grows and their capital requirements increase. This is typically when a company files for an initial public offering (IPO) and makes their stock available for purchase by the public.
An initial public offering, or IPO, refers to the process of offering shares of a private corporation to the public in a new stock issuance.
Companies can participate in secondary offerings where they issue additional shares to the public after their IPO, to raise additional capital.
The Ups and Downs of Investing: Bull Markets vs Bear Markets
As most people know, beginner or not, there are risks involved when it comes to investing in stocks and although stocks tend to go up over the long term, they don’t always go up. The terms bull and bear market are used to describe how stock markets are doing in general, that is whether they are appreciating or depreciating in value. At the same time, because the market is determined by investors’ attitudes, these terms also denote how investors feel about the market and the ensuing trends.
In a basic sense, a bull market refers to a market that is on the rise and, by contrast, a bear market is one that is in decline, typically by more than 20% from the peak to its current value.
The Case for Investing in Stocks
For some, after seeing the chart above, it might seem clear that investing in equities is the smart choice for those with a long time horizon. But for others, they may look at this chart and think something along the lines of “why take the extra risk if there is a change my savings could depreciate meaningfully – as would have been the case if you remained invested through the 2008 financial crisis – and why not just put my money in a reliable high-interest savings account”?
To answer that question and outline the case for investing in equities, especially those with a long term time horizon, have a look at the tables below. The tables show how much you would have accumulated if you had started contributing into a high-interest savings account that provided a 3% annual rate of return (the 3% is generous as the current rate is 0.80%) 50, 40, 30, or 20 years ago, compared to if you had invested in an S&P 500 index fund (an investment in the top 500 companies in the US by size) 50, 40, 30, and 20 years ago – as of January 1, 2020.
The returns are compounded annual total returns of the S&P 500 for the respective periods, not including taxes or fees. The S&P 500 is an index of the 500 largest publicly-traded companies in the U.S. and is considered the best representation of the U.S. stock market.
If you had started investing in 1980 (40 years ago), you would have experienced three bear markets, including the 2008 financial crisis (-50.9% over 1.3 years), the tech bubble in the early 2000s (44.7% over 2.1 years) and the flash crash of 1987 (-29.5% over 3 months), all of which were hard to stomach for investor. But by staying disciplined and focused on saving for the long term you would have developed a pretty solid retirement fund.
On the contrary, let’s say you could have achieved 3% annually for the same 40 years. Although you would have missed out on the massive declines in ’87, ‘01, and ’08, your account would be worth substantially less.
These might seem like arbitrary time horizons, but if you start investing at age 20 and retire at age 70, that’s 50 years. If you start at 30 and retire at 70, 40 years. Start at 25 and retire at 65, 40 years as well…you get the idea.
The purpose of this illustration is to show that starting to invest early pays off in the end. Although equity markets will fluctuate more than a high interest savings accounts, or GICs, and there will periods of time when equity investors lose money, the reason to invest in stocks is that over the long-term, stocks tend appreciate and you will likely have more money for retirement, or other goals, than you would otherwise.
Also to be noted, we have outlined how small fortunes can be achieved by investing in stocks and not once did we mention anything in regards to market timing, or ‘the right time’ to buy and sell stocks.
In later newsletters, we will dive into why investing in only an S&P 500 index fund is not a one size fits all investing strategy because of other considerations such as time horizon, risk tolerance, and overall financial goals. We will also discuss the role of professional investment managers, portfolio management and the benefits and difficulties of individual stock selection. For the time, being we hope this outlines the benefits of investing in stocks and is enough to get you excited about your financial future.
So, now that we have covered some of the basics of stocks and have provided some information to help you become more comfortable with investing, we can begin to delve into some more complex topics in posts to come.
Stay tuned for more content and please feel free to reach out with any suggestions on topics that you would like us to touch on, or any questions you may have about what was discussed in this post. The purpose of this email is to educate and help readers become sound investors, so please let us know if there is any way we can help!
In each post we plan on providing a book recommendation to help expand your investing acumen.
This month’s recommendation: I Will Teach You to be Rich – Ramit Sethi
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